PERSONAL FINANCE : Junk Bond Funds May Be Safer Than You Think

High-yield "junk bonds," already maligned before the stock market crash, have become even more tarnished since then. Which is why some experts say now may be a good time to invest in them.

The bonds, which yield more than top-rated corporate and government bonds because they are considered riskier, are seen as particularly vulnerable to default in a recession. The bonds are issued by newer or smaller corporations that are unable to get investment-grade ratings for their debt; they also are issued to finance corporate takeovers. A recession could make those issuers less able to make interest payments.

Skittish investors, scurrying to safer investments and worried about a possible recession, have shunned junk bonds since the crash. That "flight to quality" has driven junk bond prices down and yields up, to the point where on average they yield about 13.5%, or roughly 5 percentage points above Treasury notes with comparable 10-year maturities.

But does that mean you should avoid junk bonds? Not necessarily. Encouraged by those higher yields and what some believe has been investor overreaction in avoiding junk bonds, many experts say the issues--particularly if bought through mutual funds investing in junk bonds--are a good choice for investors willing to take a calculated risk.

First, junk bonds' higher yields still more than compensate for the added risk of default, even in a recession, these experts say.

Studies have shown that in recent years, junk bonds have on average consistently outperformed high-grade bonds over time, even after defaults. Over the past three years, for example, mutual funds investing in junk bonds have earned a compounded annual return of 14.5%, compared to 10% for mutual funds investing in government bonds, contends Joe Mansueto, president of Morningstar Inc., a Chicago-based firm that tracks mutual funds.

With junk bonds' 5 percentage point spread over comparable Treasuries--typically the spread has been between 3 and 4 percentage points--there would have to be a default rate of between 9% and 10% to wipe out the yield advantage for an investor holding a diversified portfolio of junk bonds, contends Edward Altman, professor of finance at New York University and a leading authority on junk bonds.

(Investors typically lose about 50 to 60 cents on the dollar in a default, because the bonds still have some value as long as the issuer has assets that can be sold to pay off bondholders. So a 10% default rate would be equivalent to about a 5% to 6% actual loss.)

The big question, of course, is what the default rate will actually be in a recession. No one knows for sure, as many junk bonds have never been tested in a major recession such as the one in 1980-82.

A 10% default rate is possible, if a couple of major ones occurred similar to this year's default of Texaco bonds (triggered by its Chapter 11 bankruptcy filing) or last year's default of LTV Corp. bonds, Altman estimates. That could make junk bonds an unwise investment in the short run. But such a high default rate is not likely to be sustained over time, he contends. So far, this year the default rate is about 5% but would be only about 1% without the Texaco default, he said.

A second advantage of junk bonds: Like other bonds, they also can rise in price if interest rates decline.

"If you think interest rates are coming down, junk bond funds are a good place to be since you get the highest yield," said Charlie Hooper, editor of the Mutual Fund Strategist, a newsletter published in Burlington, Vt.

Junk bond prices can also go up if their ratings are upgraded due to an improvement in the issuer's financial condition.

Third, contrary to popular opinion, junk bonds generally are less volatile in price than safer high-grade corporate bonds and Treasuries, Altman said. That is partly because their higher yields help insulate them from fluctuations in other interest rates; junk bond investors are less likely to unload them when interest rates shift. Thus, when interest rates shot up earlier this year, junk bonds did not decline in price as much as comparable Treasuries.

Mounting Anxiety

Of course, there are negatives. For one, interest rates could go up instead of down. That would erode the value of bonds, meaning that your total return will be cut by declines in price (if your junk bond mutual fund, for example, yields 14% but declines in price by 10%, your total return would only be about 4% if you were forced to sell it). And if there is a severe recession, no one knows for sure how high the default rate could go.